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Romick: No Pay for Play in the Market

Seeing few opportunities that meet their risk-reward criteria, the team at FPA Crescent--winner of Morningstar's 2013 Allocation Fund Manager of the Year award--is sticking to its discipline and letting cash build, says manager Steve Romick.

My name is Dan Culloton with Morningstar. I am here with Steve Romick of FPA Crescent to talk about the award, and the year of 2013 for them.

Steve, thank you for being here.

Steve Romick: Thank you. Thank you for the honor of the award.

Culloton: The fund named Brian and Mark as co-managers part way through the year, yet they have been a part of the team for quite some time. Why don't you talk about their contributions to the fund in the past and this past year?

Romick: We only have a short 10-minute interview, so it's difficult to talk about their contributions in such a short timeframe. But they are terrific. Brian and Mark joined us in late 2008 and early 2009 and have been adding a lot of value ever since then. Although they were named portfolio managers in 2013, they had functioned effectively in that capacity for the year and a half preceding that or so.

Prior to joining FPA they were both respected portfolio managers in their own right, so they came to the firm as more than just analysts, and they've taken the ball and run with it for every task they've either been asked to do early on or tasks that they've initiated for themselves. They are a tremendous value-add to our team.

Culloton: One of the unique things about the fund and the past year was the performance you were able to put up with such a large and increasing cash stake throughout the year. What was interesting to me is that, sitting on all that cash did not mean sitting on your hands, and even within the cash stake, you were able to do some interesting things such as diversifying to Singapore debt. Why don't you talk about the cash stake and what you've done there?

Romick: First it's important to understand that the cash is merely a byproduct of our investment process. Cash is not a conscious top-down allocation decision. If we don't find companies that meet our risk-reward [criteria]…because our goal first and foremost is to generate equity rates of return while protecting capital… so if we feel we can't do that in any given name, then we end up in cash.

As cash was building during the course of the year, it increased 10% or so during the course of 2013, we realized that, with all the dysfunction that existed in Washington, not that we were worried about U.S. Treasuries ultimately having an impairment, but accessibility, availability of cash at any given point in time is paramount. That cash is an option on future opportunity, to be able to put that cash to work.

We felt it was incumbent upon us to diversify some of that cash away from U.S. Treasuries. So, we exited a number of different cash substitutes back in '08, and we re-entered commercial paper, for example, in 2013. We used short-term corporate bonds, and we also bought, as you mentioned, some sovereign paper, including the Singapore sovereign paper.

They are all cash substitutes, and we want that cash available at any given point in time.

Culloton: Another interesting thing about the allocation category and the other allocation funds that were considered is that they all had significant bond stakes, even funds that had been leaning away from bonds for similar reasons that you've leaned away from bonds. But you have almost no bonds in your portfolio. Why don't you talk about that?

Romick: We can almost talk about why we don't have bonds for the same reason we don't own a lot of other higher-yielding investments. Those investments that come with a large coupon or a large yield tend to, in periods of low interest rates, when people grab onto them and bid their prices up to levels that don't justify the risk that's being assumed in owning them.

That would include not just high-yield bonds, which is most of the bond work and investment that we typically do, [but also] MLPs or real estate investment trusts. So our high-yield bond exposure is as low as it's ever been because we don't feel we're getting paid to play.

There are two things that we consider when we're looking at corporate bonds. One is, what is the spread to Treasuries, call it the risk premium? But also, what is your starting yield? Given that yields are as low as they are in the Treasury market, to go and get 5 points over the 10-year isn't giving you much of return, or 3 points over the 10-year in many cases depending upon some of the bonds. And we see over the last four years, we've had over a trillion dollars of bonds that had been issued in high-yield bonds. A trillion dollars of them, and that dwarfs anything that we've seen in history.

And in addition to that, in that same timeframe, we've had over $200-$230 billion or so in the last four years that are CCC and not rated. So these CCC and unrated bonds are issued and are coming at a point in time where borrowers have a little bit of an edge, and they're able to get bonds pushed out there in the market. They are taking advantage, they are smart, they're really trying to term out their debt.

The same thing holds true for bank debt. Covenant-lite securities hit an all-time high--45% of the issuance at this point in time, which is a huge number. So the risk we feel is greater in the system. That doesn't mean that high-yield bonds are going down tomorrow, but in a long-winded way, we're saying that we are not getting paid to play.

Culloton: Has this lack of opportunities within the sectors of the bond markets where you normally look encouraged you to pursue some of the other illiquid-type investments and vehicles that you've invested in in the past, such as real estate loans, timber, and whatnot?

Romick: I wouldn't say they've encouraged that. I think because one asset class is expensive, it doesn't therefore beget that the other asset classes are cheap. A lot of people are running into stocks today because bonds are expensive, and I just don't think that by default that really makes sense, [to think that] because one thing is expensive, therefore another thing is cheap.

But it's true, we are making a number of illiquid investments in the portfolio today, and that's really just because they're attractive in and of their own right--not because one area is expensive someplace else. Some of them we don't want to talk about because most of them are small because we run a public fund, so we can't have that much in illiquid securities or illiquid investments.

We've been making some first-lien real estate loans, as an example, that offer double-digit yields, and we're very happy with that position, but it's really tiny. We hope it gets larger, but it isn't really worth a lot of discussion given that it's relatively small size.

Culloton: You mentioned people are running into stocks because bonds don't look cheap and yields are really low, and yet stocks are pretty fully valued by a lot of measures. Yet, you are still finding select opportunities within stocks.

Romick: We're finding select opportunities. There are certain things that we're doing. Most of the opportunities we're finding is we're building positions in companies we are not willing to talk about today. But there's not lot of opportunities that meet our risk-reward. It doesn't mean the market is not going to rocket from here. We have no idea what it's going to do. We're just going to remain true to our discipline, to provide strong risk-adjusted returns.

If we don't see those investments that meet those characteristics, then we just don't buy it, and as I said, we end up with cash by default. But we don't have a lot to do; it's pretty boring inside of our offices. We're spending a lot of time doing a lot of research on companies and businesses and putting that research on the shelves and into our library, that we hope to check out at a point in time when those companies and those industries or the market corrects.

Culloton: It looks like there have been a number of technology holdings that have become apparent in the portfolio--maybe you have been building the stakes quietly for some time. Recognizing of course that you're a bottom-up investor and all of these stocks have individual stories, what is it about the technology area and the technology stocks that you're gravitating to that is attractive?

Romick: There's a lot of bad news surrounding technology in general. It was an area of the market that underperformed and the wind was blowing in our faces, and we have a tendency to lean into the wind. These companies were trading at lower multiples than they had in the past, and we felt in each of these cases that the growth rates were going to be better than the market expected. There were concerns in each of these cases as to why the growth wouldn't be a certain thing, and those concerns were valid. They are applicable whether it'd be to a Microsoft or an Oracle or a Cisco or a Checkpoint. In all of those instances, there are real concerns as to why growth might be slower in the future, reasons as to why the stocks were trading lower. But we believe that in each of those instances, the market was discounting too much bad news and that there was more opportunity available to us to be long them, and that the risk-reward was attractive. I think in terms of risk-reward, what we can make versus what we can lose.

Culloton: Steve, thank you very much for your time today. Congratulations.